The limits of monetary and fiscal policy

Following two rounds of monetary and fiscal stimulus, we are relearning that neither monetary nor fiscal policy is likely to have long-lasting effects on growth or unemployment. The tepid growth of US output and employment in response to two rounds of monetary and fiscal stimulus since 2008 suggests that a third round of either monetary or fiscal stimulus in 2011 would lead primarily to higher inflation and a higher ratio of government debt to gross domestic product (GDP) in 2012.

Key points in this Outlook:

Monetary policy has reached its limits. The significant risk of deflation that prompted last year’s second round of quantitative easing has passed, and with inflation rising, monetary stimulus is no longer an option.

Two rounds of fiscal stimulus have produced neither a sustained rise in growth nor a sustained drop in the unemployment rate. Another round would merely increase deficits and debt levels.

Rather than enacting further stimulus, the Federal Reserve should aim for lower, steadier inflation, and Congress and the president should cut spending and reduce tax expenditures to finance lower tax rates and reduce the debt-to-GDP ratio.

US growth slowed during the first half of 2011 while the sovereign-debt crisis ebbed and flowed and unsettled financial markets, just as occurred in the second quarter of 2010. It is no surprise under these circumstances that the Fed has been under pressure to initiate another round of quantitative easing or that the White House, former Treasury secretary Lawrence Summers, former chair of the President’s Council of Economic Advisers Laura Tyson, and former vice chairman of the Federal Reserve Alan Blinder have suggested the need for another fiscal stimulus package. While rising core inflation has appropriately engendered hesitancy on a third round of quantitative easing, rising federal debt has–also appropriately–done the same for fiscal stimulus. If stock markets fall again or unemployment rises further or even stays the same, expect calls for more stimulus to grow louder.

Nevertheless, after two rounds of monetary and fiscal stimulus since 2008, the time has come to ask whether we have reached the stage of diminishing marginal benefits from returning to either approach. The recent rise in core inflation suggests that we are approaching the stage of negative returns for further monetary stimulus, while the alarming rise in government debt signals that the same may be true of further fiscal stimulus.

This is not to say that an abrupt reversal of the Fed’s second round of quantitative easing and a boost in interest rates, along with a trillion-dollar cut in government spending over the next year, would make the economy better off. Such measures would risk a global depression. But it is time to recognize that monetary policy cannot do much more than avoid deflation while keeping inflation low and stable. For its part, fiscal policy can stabilize growth and employment while providing a temporary boost when private demand slows, and conversely tightening–and thereby reducing debt–when private demand overheats. Because monetary and fiscal policy are countercyclical, their impacts on growth and employment are temporary and tend to be reversed once they are withdrawn. In 2011, after repeated rounds of fiscal and monetary stimulus, would efforts to boost the economy or support asset prices with additional stimulus of either kind be endeavors where the long-run present discounted value of the costs outweighs the short-run benefits?

Consider some relevant history. After the volatility of the 1970s and early 1980s, US policymakers broadly employed monetary and fiscal policy as countercyclical, stabilizing measures to lower the volatility of growth and inflation. A less volatile economy promotes better decision making by households and corporations and thereby enhances productivity growth while allowing unemployment to drift downward.[1] The period of less volatility in macroeconomic behavior came to be called the “Great Moderation” in the United States. It lasted from about 1985 to 2007, when the housing bubble burst and led to a global financial crisis. The figure shows that over the full period, the mean GDP change per year is 3.27 percent with a relatively large standard deviation of about 2.7 percent. During the Great Moderation, the standard deviation is less than half that at only 1.3 percent.

In retrospect, the Great Moderation and the benign outcome for the economy of well-managed countercyclical monetary and fiscal policy had its downside. The business cycle was declared largely dead. Many became convinced based on less volatile growth and inflation that a serious downturn–including a steep drop in home prices–was virtually impossible. But such a conviction, as it turned out, created a bubble in home prices that ultimately burst and led to a serious global financial crisis, the aftermath of which is still with us.[2]

The period following a financial crisis can prove and has proved very difficult for policymakers attempting to affect the level of growth and employment over an extended period with the usual countercyclical policy tools designed essentially to stabilize the paths of these variables rather than affect their levels. This is true even if those tools are employed on an extraordinary scale, as has been done with both monetary and fiscal policy since 2008.

Now in mid-2011, the evidence that expansionary monetary and fiscal policy measures can no longer support the economy or financial markets is accumulating. After substantial second rounds of additional quantitative easing (QE2) and additional fiscal measures late in 2010, growth in 2011, at or below 2 percent so far, is lagging well below expectations of the markets and the Fed at the beginning of the year. Moreover, we are already being warned about the negative impact on growth later this year and in 2012 when existing fiscal stimulus is withdrawn.

The Limits of Monetary Policy

After the June 22 meeting of the Federal Open Market Committee (FOMC), the Fed revealed that it had lowered its growth forecast range for 2011 from the 3.4-3.9 percent range in February to a 2.7-2.9 percent range. Other forecast changes included a higher unemployment rate and, disconcertingly, higher inflation forecasts, including even a boost in the core Personal Consumption Expenditures (PCE) inflation forecast. In February, the Fed’s core PCE inflation forecast was 1.0-1.3 percent. Now, at midyear, it is 1.5-1.8 percent, still in the Fed’s 1.5-2.0 percent “comfort range” but edging up toward a worrisome level that might lead to a Fed tightening if the 2.0 percent outer bound were reached.

The Fed’s own forecast changes suggest that in the middle of 2011 the US economy has entered a period of mild stagflation: lower growth and higher inflation.

Broadly speaking, the Fed’s own forecast changes suggest that in the middle of 2011 the US economy has entered a period of mild stagflation: lower growth and higher inflation. That said, the Fed is expecting and hoping that the stagflation scenario will generally atrophy, with higher growth in the second half of 2011 and in 2012 and lower inflation during 2012 and 2013. Those outcomes are possible and may occur. But the leeway to use additional monetary easing or fiscal stimulus to achieve these outcomes may largely be unavailable now.

The Fed’s uncomfortable situation, acknowledging mild stagflation while hoping it will go away, was highlighted at the press conference with Federal Reserve chairman Ben Bernanke after the June 22 FOMC meeting. One reporter asked, “Given the Fed’s belief that the recent uptick in inflation is transitory, why wouldn’t the Fed consider taking more action to stimulate growth?” Underlying the question is the concern that current modest growth levels may not be sufficient to lower the unemployment rate. Chairman Bernanke’s response, essentially resisting the implied call for a third round of quantitative easing (QE3), had two parts. First, he reminded his audience that last year’s QE2 had been undertaken to combat a “significant risk” of deflation and that that risk is no longer present. Second, noting that the Fed would continue to watch economic growth trends and act “appropriately,” he admitted that additional stimulus measures simply might not work. Bernanke described measures such as additional securities purchases or cutting interest on excess reserves paid to banks as “somewhat untested” and having “their own costs.”

The reluctance of the Fed and its chairman to employ further quantitative easing measures even as growth has slowed and unemployment remains high is tied to a basic reality. Monetary policy cannot produce a sustained impact on real economic variables like growth and unemployment. The reason, as we learned in the 1970s, is that persistently attempting to boost growth or reduce unemployment with more accommodative monetary policy results in higher and higher rates of inflation that eventually must be terminated at great cost to the economy.

The Fed currently faces a delicate situation because of its broad dual mandate, whereby it is supposed to simultaneously promote both stable inflation and full employment. Suppose for a moment the Fed were to undertake QE3 to reduce the rate of unemployment. It might succeed over a short period if inflation rose fast enough to exceed wage increases, so that real wages fell. Firms facing lower labor costs might hire more labor, but then wage demands would rise to compensate for the surprise inflation increase, and the incentive to continue more hiring would disappear unless an even higher, unpredicted round of inflation ensued.

When actual inflation rates rise by enough to push up wages, inflation expectations are further boosted, thereby signaling that heretofore stable inflation expectations have become “unanchored.” At that point, inflation becomes self-reinforcing: higher expected inflation leads to further price increases. This is well understood by Chairman Bernanke and virtually all FOMC members, who have said clearly that evidence of a persistent rise in expected inflation above current levels would threaten the Fed’s inflation-stability mandate and would require tighter monetary policy. During the current post-financial crisis period, such a choice would be a painful one. The US economy has shown little evidence of a sustained positive response to easing monetary policy, and given expectations that current high levels of accommodation will persist for “an extended period,” an abrupt cut in the monetary stimulus could produce a sharp drop in asset prices and a significant rise in unemployment.

A rise in expected inflation would also push up interest rates as lenders and buyers adjusted to a faster expected drop in the purchasing power of money. Higher interest rates would boost interest costs for deficit financing, thereby further increasing future deficits. A way to inflate away the debt burden and reduce the debt-to-GDP ratio is to have actual inflation exceed expected inflation, which, of course, becomes self-defeating when borrowers and lenders adjust to a scenario of accelerating inflation.

In reality, the two components–stable inflation and lower unemployment–of the Fed’s mandate are incompatible. The only exception to this principle is a confluence of lower growth and deflation risks such as that which emerged in 2008 and again in mid-2010. Then, as Chairman Bernanke has often noted, additional monetary easing is appropriate to contain deflation risks, which, if left unchecked, could reduce growth and raise unemployment.

The Limits of Fiscal Stimulus

Fiscal stimulus, tax cuts, and larger government expenditures usually produce higher growth shortly after they are enacted. The 2009 growth rate was boosted, perhaps by a percentage point, by the $800 billion-plus stimulus package enacted early in 2009. The unemployment rate was little affected, largely because hiring is a long-run decision, the consequences of which outlast the temporary period of higher growth induced by fiscal stimulus. Government spending increases can only be finite, given the limits imposed by their positive impact on deficits and debt. Higher government spending growth is eventually followed by a period of lower spending growth, which results in a period of lower growth. The net effect on growth over time is usually quite small.

The same is true of temporary tax cuts. Payroll tax reductions and other stimulus measures enacted in December 2010 lifted disposable income and growth partly by offsetting the negative effect on disposable income from higher energy prices. But when the payroll tax reductions and other stimulus measures terminate at the end of 2011, growth will, all other things equal, be lowered in 2012. Warnings have already appeared that the phaseout of the second round of stimulus measures in 2010, made necessary by the need to reduce debt accumulation, will reduce the 2012 growth rate by 1.5 percentage points.[3] This is not to say that the stimulus measures should not be phased out. They should be. Rather it is to remind that, if they were extended, we would end up with another increase of $300-400 billion in debt while still facing the withdrawal problem a year later.

The impact of most short-run fiscal stimulus is, by design, to move growth to a higher level immediately after enactment. But once the stimulus is withdrawn, the sustained, targeted impact on growth disappears, just as the sustained negative impact of easier money on the unemployment rate disappears once wage earners boost wage demands in the face of higher expected inflation. This pattern is evident in the “cash for clunkers” programs, whereby households are subsidized to buy a car during a specific time period. The effect is to accelerate car purchases until the end of the period, but when the subsidy goes away car purchases are depressed. The net impact on car sales over time is close to zero.

The pattern, whereby more spending now is exchanged for less spending later, can help to mitigate a normal business cycle by offsetting oscillations in private demand, but it cannot permanently raise the growth rate by virtue of the fact that deficit spending is financed by higher levels of government debt. The higher levels of debt, especially when they exceed historical norms as has recently been the case in the United States, lead to expectations of higher future taxes to stabilize the level of debt. Expectations of higher future debt, along with the withdrawal of necessarily temporary fiscal stimulus, result in lower growth, and, as we saw last year, in calls for still- further stimulus measures. As noted earlier, most estimates suggest that the $800 billion-plus stimulus package in 2009 raised the US growth rate that year by about a percentage point. The positive impact on growth faded rapidly during 2010 and actually became close to zero during the last half of the year. As the boost from fiscal stimulus wore off during 2010, growth slowed at midyear. The result was another stimulus package enacted in December 2010, accompanied by QE2 in response to the mid-2010 slowdown, which, as we have seen, only modestly boosted growth during the first half of 2011.

The combination of current tepid growth and high unemployment and rising inflation presents a difficult challenge to the Fed and Congress as deficit-reduction talks proceed. Current levels of inflation and debt suggest, however, that another round of monetary and fiscal accommodation risks unanchoring inflation expectations and leading to still-higher levels of debt. In short, while such measures might provide a short-term boost to growth, the long-term costs could outweigh the short-term benefits.

Fiscal consolidation may not be as painful as supposed based on an extensive survey by the International Monetary Fund of studies of past fiscal consolidations.[4] The main conclusions of these studies seem to have guided the deliberations of the debt commission. Overall, fiscal consolidation usually reduces growth and raises unemployment in the short run. But spending cuts cause less pain than tax increases, partly because central banks provide less monetary stimulus after tax increases that may add to inflation. Beyond that, tax increases, especially tax rate increases, raise the economic cost of collecting revenue by distorting resource allocation.

Spending cuts, especially those made to politically popular programs like entitlements, are less harmful to longer-run economic growth because they enhance the credibility of the effort to reduce the buildup of debt and the size of expected tax increases over time. This, in turn, may enhance confidence of households and businesses as they look to the future. The potential for such an increase in confidence is enhanced the more the prospects for government solvency are improved by fiscal stringency. These two considerations are probably linked to Chairman Bernanke’s emphasis on current enactment of credible multiyear deficit-reduction measures.

Reaching the Limits

The painful truth is that the “best” part of fiscal stimulus comes right after it occurs. The worst part comes when it wears off, and debt accumulation precludes further stimulus by threatening government insolvency. The same is true of monetary policy when, after a boost that may induce more hiring when prices rise faster than wages, monetary policy has to be moved back to neutral or tightened before inflation expectations become unanchored.

The painful truth is that the “best” part of fiscal stimulus comes right after it occurs. The same is true of monetary policy.

While fiscal consolidation is never easy, the “best” part of the consolidation arrives only after spending is cut and growth slows then starts to rise again as the prospects for solvency improve and expected future tax increases fall. Further, the timing of the arrival of the eventually positive effects of fiscal consolidation is highly uncertain, and it may exceed the patience of lawmakers and the electorate.

There remain many empirical and theoretical controversies surrounding the use of countercyclical monetary and fiscal policy. Most economists would probably agree that, except in a severe financial crisis, like the 2008 Lehman Brothers crisis, monetary policy should be directed primarily at maintaining a low, stable inflation rate. Trying to stimulate growth while reducing unemployment with monetary policy only works temporarily, if at all. It risks higher inflation, which will ultimately have to be controlled by sharp monetary tightening and attendant lower growth and higher unemployment, such as occurred after 1979. The same painful truth is tied to fiscal policy, with debt accumulation playing the role that inflation plays with monetary policy as a signal that the limits of expansionary policy have been reached.

There is little evidence to suggest that either monetary or fiscal policy can produce sustained effects on the level of growth or unemployment over time. A possible exception is the stabilization of the growth paths of such variables, such as occurred during the 1985-2007 Great Moderation when lower volatility of growth and inflation may have enhanced productivity growth and allowed for a downward drift in the natural rate of unemployment. But even these suggestions are highly controversial.

The tepid and weakening response of the growth of US output and employment to two rounds of monetary and fiscal stimulus since 2008 suggests that a third round of either monetary or fiscal stimulus in 2011 would lead primarily to higher inflation and a higher ratio of government debt to GDP in 2012. The Fed would do better to aim for lower and steadier inflation, while Congress and the president should cut spending and reduce tax expenditures to finance lower tax rates and achieve a stable and then lower debt-to-GDP ratio.